Is it time for some downside protection?

While equity markets appear attractive, a lot of money is flowing elsewhere these days. For retirees and pre-retirees, it might be time to take a look at some defensive strategies.

For retirees and pre-retirees, it might be time to take a look at some defensive strategies. Picture: istock

We’ve all felt the sting of inflation the past couple of years but markets have been good – stocks are grinding higher and dividends are lining investors’ pockets. Deep breath, we know this won’t last forever.

While equity markets appear attractive, a lot of money is flowing elsewhere these days – just look at all the hype around private assets.

For retirees and pre-retirees, it might be time to take a look at some strategies that offer a layer of downside protection.

But first, the obvious: retirees love their dividends. Nothing better than a steady stream of income from your favourite blue chip, right?

The problem is some investors can get too caught up in the lure of dividends and franking credits, says independent financial adviser Nathan Fradley.

“Particularly in retirement, there can be a tendency to pursue just dividends and dividend yields,” Fradley tells The Weekend Australian.

“But a company that pays a dividend doesn’t invest as much in itself, because it’s paying out its profits, fundamentally. So it can grow to an extent but you’re going to take a hit on that front (if your money’s in income stocks).”

Splitting up the pot

Splitting up the retirement pot into separate buckets is a good way to get some downside protection, by getting a little bit of growth while looking after the overall savings pot, Fradley adds.

“For investors wanting to understand downside protection, one of the worst things they can do is sell shares when markets are down. That’s often forced on retirees,” he says.

“Something to do there is the old-fashioned bucketing strategy. Having assets in separate pools, say, a high growth, a balanced and a cash bucket, allows a retiree to choose where their pension payments are coming from.”

This means that if the market turns, you don’t have to draw down on high growth assets at the absolute worst time.

“In terms of protection, you’re reducing sequencing risk (that you retire in a down market), because you’re saving for that downside,” Fradley says.

For pre-retirees, the key is to take steps early ahead of the move out of the workforce. New research from life insurer TAL shows that more than a third of workers aged 55-plus feel unprepared for retirement and about the same number have taken no action to prepare.

Among the rest, those who topped up their investments, particularly their superannuation, felt the most confident about their finances, the data shows.

Number one enemy

Inflation is the number one enemy of the retiree, says Minchin Moore investment director Doug Turek.

“The pre-retirement years and early stages of retirement are very risky times for retirees because they can get caught out with a period of prolonged poor sharemarket returns or high inflation,” Turek tells The Weekend Australian.

Like Fradley, Turek sees some investors cling too tightly to equities in retirement. Instead, bonds are worth a look for those seeking low-risk income, he says. And for the more adventurous, there’s a currency hedging option.

“Government bonds are getting good returns right now, so most asset managers are very positive or bullish on high-grade bonds. They lock in your income, which you don’t get from a term deposit.

“It can be Australian bonds but, personally, I think the most defensive option is US dollar bonds bought by an Australian in US dollars,” Turek says.

“It’s quite a sophisticated strategy because you get a lot of Australian dollar currency risk but on the other hand you want currency reward; 10 out of 12 times the Australian sharemarket has fallen more than 10 per cent, so has the Australian dollar.”

Income - with a difference

For those who can’t move past dividends and franking, one option in the marketplace is something like the Merlon Share Income Fund, which uses derivatives to reduce the equity exposure of the fund to 70 per cent while maintaining 100 per cent of the franked dividends from the underlying share portfolio.

On a three-year basis, the fund has returned 12.4 per cent, net of fees, with a gross distribution yield of 6.5 per cent, against a benchmark return of 7 per cent.

Rather than look just for companies that pay the highest dividends, Merlon focuses on free cash flow and takes a bearish stance on valuations, according to co-portfolio manager Andrew Fraser.

“A lot of retirees that try and build their own portfolios will look at the dividends first and foremost, but there’s plenty of empirical evidence to show that investing on the basis of dividend yield is actually a surefire way to lose money,” he says.

“We actually focus on cash flow. And ultimately, you know, we believe that dividends are only sustainable if the companies that are paying them generate sufficient free cash flow through time to back those dividends.

“When we make investments, we’re very much focused on bear-case valuation scenarios so if we get something wrong, we have an understanding of what our risk of permanent capital losses is.”